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A Theoretically Defensible Measure of Risk: Using Financial Market Data from a Middle Income Context

While economic theory assumes that risk is of central importance in financial decision making, it is difficult to measure the uncertainty faced by investors. Commonly used empirical proxies for risk (such as the moving standard deviation of the returns on an asset) are not firmly grounded in economic theory. Risk measures have been developed by other studies, but these are generally based on subjective weights attaching to a range of objective component indicators and are difficult to replicate. The contribution of this paper is to develop a methodology to construct theory-defensible empirical risk measures. It has the advantages of being explicitly consistent with economic theory and easily replicable. We illustrate this methodology by specific application to the South African context. The time-varying risk measure developed in this paper is consistent with the expectations hypothesis and captures the asymmetric nature of shocks. This measure reflects investors’ risk perceptions and accords with the literature on risk in South Africa.

Working Paper 064
1 November 2007
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